February 18, 2017

Debt funds - What lies ahead?

In the past one year, Gilt funds, Dynamic bond funds and
other medium to long term bond funds gave excellent returns. Excellent because
it’s truly an extra ordinary scenario when fixed income instruments end up
giving you close to 15% p.a. returns. Alas, if only these returns came every
year there would have been no need to break our heads over number crunching and
generating returns.

The following events were the reason why these instruments
gave such high returns:

i)Rate cut cycle by RBI

ii)

Demonetization

Let’s go into some detail because you MUST know about your
money.

Rate cut cycle by
RBI:

RBI has been on an interest rate cutting spree
for the last 18 months or so. Bond prices are inversely proportional to
interest rates, so when interest rates fall the bond prices go up and vice
versa. We save the explanation for another report as it is little complicated.

Repo Rate Chart (RBI)

The above chart depicts the fall in REPO rate from 8% to
6.25% over the last 18 months. This pushed up the prices of existing medium to
long term bonds and gave handsome returns to their investors.

Demonetization:

When the Government asked people to go deposit their old
notes in the banks, the banks were flooded with money. Now as per the governing
regulations, the banks must maintain their deposits in specified assets which
include sovereign bonds (GILT). How much? That is determined by the Statutory
Liquidity Ratio or SLR. So, heavy buying was seen in medium to long term
government securities and the prices of these securities shot up overnight and
gave investors astronomical returns.

See the chart on the next page to get a visual idea of the
overnight increase in prices of GILT securities. We have used L&T Gilt fund
as an example.

L&T Gilt fund returns chart

So, what lies ahead for debt investors?

- - No more demonetization

- - Rate cut cycle nearing an end

The above two points mean that we won’t see double digit
returns in debt funds anytime soon unless it is some doomsday scenario. For
example, a war breaks out and markets are crashing and thus investors start
dumping stocks and run to the so called “Safe Assets”. Infact, if you buy any medium to long term debt fund now,
you will see hardly see any returns as bond prices will now consolidate. So,
does that mean we no more invest in debt funds? Not really.

Demonetization was unexpected and an icing on the cake for
our portfolio which was 68% in debt funds. Our main ideology was that RBI will
aggressively cut rates and debt funds would give close to 10% to 11% returns
annually. We got close to 15% thanks to Demonetization. Now that we see
diminishing returns in medium to long term debt funds, we shift to shorter duration debt funds. Why? Because these bonds are less sensitive to
interest rates.

For example, consider this:

Fund

Duration

Average Maturity

L&T Gilt Fund

Long term

9.60 Years

L&T Ultra Short Term

Ultra-Short

0.82 Years

L&T Liquid Fund

Extremely Short

0.06 Years

The shorter the average maturity of the holdings of a fund,
the lesser the sensitivity to interest rates. So, this year which funds do we invest in and in what
proportions? We have considered the following points while selecting the
funds for our clients:

Assets Under Management

Average Maturity

Modified Duration

Expense Ratio

Credit Rating

Exit Load

Ease of Transactions

Always keep in mind - Choose "Growth" option and not "Dividend" as it is more tax effective and thus gives higher post-tax returns.

We have saved our clients from the hassle of selecting the right debt fund from thousands of available schemes by selecting four schemes for them. Join our SEBI registered Premium Advisory Servicesand get access to cutting edge research reports and portfolio guidance on long term investing.